While stock options are often perceived as one of the more complicated asset classes, they offer significant versatility, value for money, and liquidity to your investment portfolio.
The issue is understanding stock options and how to trade them.
This article will help you build a solid foundation so you have a better understanding of how stock options work.
Note that this article is about stock options that are tradable in financial markets. It’s not about “employment” stock options (those you’d get from your employer as part of your salary/compensation).
What Are Stock Options?
A stock option is a contract that gives its buyer the right, but not the obligation, to buy or sell a stock at a future date at a pre-determined price.
Okay, that’s a bit of a mouthful. So let’s break this down, shall we?
A stock option is:
- a contract that gives its buyer
- the right
- but not the obligation
- to buy or sell a stock at a future date
- at a pre-determined price
Put simply, it gives you – the buyer of the stock option – the right (but not the obligation) to do something in the future.
The specific thing you’d “do” is either to either buy or sell an asset in the future.
And you’d buy or sell it at a pre-determined price.
Stock Options from a Seller’s Perspective
Note that we said that a stock option is a contract that gives its buyer the right, but not the obligation, to buy or sell a stock at a future date at a pre-determined price.
Where there’s a buyer, there will of course, also be a seller involved.
For sellers, an option is a contract that requires its seller to buy or sell a stock at a future date at a pre-determined price.
In exchange for committing to buy/sell an asset (i.e., being legally obligated to buy/sell it), the seller of the option gets a “premium”.
Essentially, this “premium” is a fee.
If the buyer of the option chooses not to exercise their option (i.e., they choose not to buy/sell the asset), then the seller keeps the fee as their profit.
If, on the other hand, the buyer of the option exercises their option (i.e., they choose to buy/sell the asset), then the seller must sell/buy the asset in question.
What Types of Stock Options Are There?
There are really two types of options contracts, and it really boils down to two different ways of saying “long” and “short” options.
There is a history to these terms, but let’s focus on learning the market before getting to the history.
- Call Option: A call option represents an option to buy shares of the underlying equity at a certain price in the future prior to (or at the point of) the option’s expiration.
- Put Option: A put option represents an option to sell shares of the underlying equity at a certain price in the future prior to (or at the point of) the option’s expiration.
How Does Each Stock Option Work?
So, we gave you the types of options, but you can trade both types of options as either the buyer or the seller.
This means there are essentially four different ways for you to use options.
- Call Option Buyer: As the call option buyer, you pay a small premium for the contract. Then, you have the right but not the obligation to buy shares of the underlying stock at a certain time in the future at a pre-determined price.
- Call Option Seller: As the call option seller, you collect a small premium from the buyer. Then, you have the obligation to sell shares of the underlying stock if the buyer chooses to exercise their option or upon contract expiration if the option is “in the money” (more on that later).
- Put Option Buyer: This is essentially the same as the call option buyer, except you have the right but not the obligation to sell shares of the underlying stock in the future prior at a pre-determined price.
- Put Option Seller: Again, very similar to the call option seller, except you have the obligation to buy shares of the underlying stock if the buyer chooses to exercise the option or upon expiration if the stock is “in the money.”
How Do Option Expirations Work?
Option expiration is an extremely important part of trading options.
You should always know what your option expiration is because prices tend to get more volatile as the contract approaches expiration.
There are three important terms to know that describe where the current underlying stock price falls as it compares to the strike price. But it’s important to remember that a call option and put option are the inverse of each other when it comes to relating strike price to current price.
- In the money: When the underlying stock is currently trading above the strike price for call options (or below the strike price for put options), the option is considered “in the money.”
- At the money: For either call or put options, if the stock is trading at exactly the strike price, it is considered “at the money.”
- Out of the money: When the underlying stock is currently trading below the strike price for call options (or above the strike price for put options), the option is considered “out of the money.”
Just to make things more complicated, there are two option styles that affect how investors can exercise their options, including:
- American-style options, and
- European-style options
Note that these style of options have absolutely nothing to do with geography.
So, you could be in America and buy European-style options (and vice-versa). It’s merely a naming convention.
With American-style options, buyers can exercise their option at any point prior to, and including the point of expiration.
With European-style options, buyers can only exercise their option at expiration.
In either case, buyers of options that are “in the money” will be seeing profits.
For the most part, options contracts will have expirations every month.
However, some stocks that see lower liquidity might have expirations every other month or more.
By contrast, stocks that see heavy activity might have weekly or daily expirations to accommodate more trading.
Investors who are just starting out should generally stick with monthly expirations for the consistency and the liquidity in those contracts.
What Is The “Option Tree?”
The option tree is the grid on which your broker will show option prices.
The center row shows the strike prices offered for that underlying stock, and it separates the two sides of the tree.
The left side shows information about call options, and the right side shows information about put options.
There will be lots of different columns on either side, but it’s important to note that options are priced on a per-share basis.
Since all options contracts represent 100 shares of the underlying stock, you multiply the quoted contract price by 100 (move the decimal point two places to the right) to find out how much that contract will cost you.
As an example, let’s say Apple Inc.’s stock is currently trading at $156 per share.
Let’s pick a strike price of $170 and look at the “ask” price, or the price sellers are “asking” buyers to pay.
Suppose the price of the $170 call option expiring in January 20X2 is quoted at 2.96.
That means the price of the option per share is $2.96, so the “buying power” needed to buy that option is $296.
How Do I Exercise Long Options?
Most stock options are European style, meaning they can only be exercised at expiration.
This is usually done automatically depending on whether your option is in the money or out of the money.
American style options can be exercised by contacting your broker and requesting them to manually exercise.
In either case, you should definitely know the style of option you are trading so you understand the risks involved.
What Market Do Options Trade On And What Are The Hours?
Options are generally traded during regular market hours.
While you might see after-hours fluctuations in the price of the underlying stock, options markets open and close at the regular opening and closing bells, respectively.
What’s Next – Stock Options Explained
Stock options are often perceived as one of the more complicated of the asset classes, but you should now have a good understanding of how the options markets work and whether they will be a benefit to your portfolio.
It takes a long time to fully grasp the intricacies of the options markets, but understanding the structure of the market and how assets move from one party to the other is critical to your journey.
Imagine sitting down at a baccarat table and knowing nothing about the game.
Knowing the rules is the first step, which is then followed by strategy.
Learning on your own or even studying from rigorous finance and investing courses to help guide you can vastly improve your time spent on learning financial concepts so you can get to applying them even faster.